Economist, Telegraph Columnist, Broadcaster

Euro crisis roars back to savage Spain

“Today the problem is solved,” declared French President Nicolas Sarkozy just five weeks ago. “How happy I am a solution to the Greek crisis, which has weighed on the economic and financial situation in Europe and the world for months, has been found”.

Just when you hoped it really was “solved”, the “eurozone crisis” has roared back onto the global agenda. Like a dripping tap, a lingering bad smell, the fundamental contradictions at the heart of monetary union can be blanked-out for a while but refuse to go away. The busted banks, the grotesque indebtedness, the inherent contradictions – in recent days they’ve all burst back into view.

The eurozone has deeply entrenched economic, financial and political problems. No amount of tub-thumping – by Sarko, European Central Bank President Mario Draghi or anyone else – can change that fundamental truth. The focus has been on Greece but now it’s most definitely on Spain. Will Spanish debt woes spiral out of control and, if so, can they then be contained? That’s the one trillion euro question. But how much is that in pesatas?

Spain is the fourth-largest eurozone economy and the 12th biggest on earth. Spanish GDP last year was almost five times that of Greece. On the surface, Spain’s government finances don’t look bad, with national debt at 68pc of annual GDP – around half that of Italy.

Yet Spain has a vast, and much less widely recognized stash of private sector debt. Global bond markets, previously sedated by ECB “funny money”, now realize that a big slice of those liabilities could land on the government’s balance sheet.

Back in the 1990s, in the run-up to monetary union, the Spanish government “de-leveraged”, cutting back debt in order to comply, or almost comply, with the unfortunately-named “Stability and Growth Pact”. A national determination to maintain Spain’s massive construction boom, though, a country-wide real estate fixation in fact, led to an increasing reliance on private sector debt instead.

As eurozone membership approached, Spain’s household debt tripled. Spanish companies gorged themselves too and are now servicing six times more debt relative to output than their German counterparts and twice as much as companies in the States.

The result is that total private sector debt in Spain is almost 300pc of annual GDP, half as much again as Italy. With property prices 30-40pc down on their 2007 peak, swathes of non-performing loans lurk on the balance sheets of Spanish cajas, the country’s far-from-transparent savings banks.

Yes – Spanish sovereign debt is relatively low. So was Ireland’s before Dublin was forced to find vast sums, despite some pretty brutal restructuring, to prop-up the country’s bloated banks. In 2007, Irish government debt was just 25pc of GDP. That ballooned to 42pc the following year as confidence ebbed and is now no less than 105pc of GDP, state debt having sparked Ireland’s bail-out and related crippling austerity program.

The Irish, of course, decided to stand behind their banks full-square. Spain won’t do that but, to prevent a wave of bank-busting defaults and untold social unrest, of lot of Spanish private debt, sooner or later, will be “socialized”. Madrid’s boasts of “low sovereign debts” will then be turned to dust.

That will mean, in turn, a whole new wave of spending cuts. Yet even before that happens, Spain is hurting badly. Unemployment hit a record 24pc in March, by far the highest in the industrialized world and more than double the 10pc EU average. Almost half of Spain’s youths are unemployed.

In a bid to boost employment, Prime Minister Mariano Rajoy’s government passed new laws making it easier to cut wages and lay people off. The Spanish unions responded with a general strike, which became a national demonstration. The protests turned violent, bringing mass arrests, tear gas and a hail of rubber bullets.

Ahead of the upcoming ECB summit in Barcelona, some protesters – both workers and students – have been kept “in detention”, accused of plotting further “anti-system activities”. A few Franco-era laws remain on Spain’s statute book and the now deeply-paranoid authorities are using them. In the wake of a third round of austerity measures just announced, the Interior Ministry wants to make the Criminal Code even stiffer, comparing recent protests with the terrorist activities of the Basque separatists. Behind the low-government-debt façade, then, Spain’s situation is grave indeed.

On top of that, last week we learnt that Spain has tipped back into recession, with GDP shrinking 0.3pc in the first quarter. The government predicts a 1.7pc contraction in 2012, a view many commercial analysts consider too rosy. As the economy slows, tax revenues fall and welfare payments rise, of course, making the fiscal position worse. Ministers admit public debt will hit 80pc of GDP by year-end, up from 36pc as recently as 2008. That’s before any systemic panic, which would see droves of private debtors throw themselves onto the state.

Spain’s benchmark 10-year bond yield exceeded 6pc last week, in the danger zone that sparked bail-outs elsewhere. Just a few weeks ago, the ECB flooded eurozone banks with liquidity under the Long-Term Financing Operation – its “game-changing” three-year lending scheme. Spanish borrowing costs have since jumped 100 basis points. Insuring £10m of Spanish debt for five years using a “credit default swap” now costs 7-times more than insuring its German equivalent.

Was there ever a more stark illustration that monetary union doesn’t work, and cannot work unless member states agree, to a very significant extent, to merge their bank accounts? What are the chances of that? Microscopically small, I would say, and getting smaller.

The spectre of another eurozone bail-out looms large – only this time far bigger than Greece, involving much larger numbers and in one of the world’s major economies. Spain must repay a €11.9bn bond on 30th April, and another €12.8bn loan at the end of July. If investors refuse to finance this re-payment at an “affordable” rate, what happens next? The answer is that nobody knows.

Greece has already enacted the largest sovereign debt restructuring in history to avoid a big, disorderly default. Pulling that off involved a €110bn EU/IMF package in May 2010, another €170bn this year and a hefty bond-holders “haircut”.

What would it take in Spain if that’s what in took in Greece? Spain is a “grown-up” economy. If Spain needs a bail-out, assuming one can be afforded (a big if), then who’s next? Where does this madness end?

Under Rajoy, Spain has been trying to get it finances in order, but the challenge just seems too great. Faced with public disorder, his government has clamped-down hard. But now, to appease the domestic mob, Rajoy has been thumbing his nose at the Eurocrats, telling them their austerity demands are “madness”. How much longer, in the face of such defiance, until “eurozone-solvents” like the Germany and Holland lose patience? Leading Dutch politicians now say their country should quit the euro. It surely can’t be long before this view becomes “acceptable” in Germany too.

In February, Spanish banks’ net ECB borrowing was €169.8bn – a staggering 47pc of ECB lending to all eurozone banks. In March, that figure surged again, to €316.3bn. Spanish banks are now under intense pressure and that distress, as it bursts into the open, will soon be dumped on the state.

“Economic spring is in the air,” said International Monetary Fund supremo Christine Lagarde, chiming in behind Sarkozy. Nothing as dramatic as a Prague spring or an Arab spring, one hopes. But the signs for Europe are ominous.